The 100 Best Small Companies

In Pixar's (PIXR
) megahit The Incredibles, a retired superhero and his family pool their talents to triumph over mediocrity. Taking their various superpowers off the shelf, they foil a villain named Syndrome whose evil goal is to eliminate all high achievers from society. The family flick -- which has brought in more than $630 million in worldwide ticket sales -- helped propel Pixar Animation Studio onto this year's Hot Growth list of America's fastest-growing small companies.

The Incredibles also serves as an apt allegory for BusinessWeek's annual survey of high-achieving small fry. What these companies prove is that talent, teamwork, and creativity often win out, even against tough foes like a struggling economy and fierce competition. Most of this year's top performers have hit on innovative ideas or tapped into economic trends that continue to fuel their growth. Some are famous names. But many have toiled in obscurity for years -- even decades -- tweaking their business models multiple times before finally hitting on winning formulas. What they all have in common is that, like the Incredibles family, they've learned to exploit their special strengths to persevere against rivals. And there's not a hint of mediocrity among them.

For Pixar, the winning mix has been talent tempered by restraint. The 19-year-old company -- which makes its Hot Growth debut at No. 32 -- has released fewer than one film a year. Chief Executive Steven P. Jobs of Apple Computer Inc. (AAPL
) fame even brags that on each of its six films to date, Pixar has incurred additional expenses to stop production and fix problems with the stories. "Quality is more important than quantity, and in the end, it's a better financial decision anyway," says Jobs. "If you can make a film a year that's a home run, it's a lot better than hitting two doubles." Hits such as Toy Story, Finding Nemo, and The Incredibles have brought in billions in box-office receipts and merchandise sales. Over the past three years, Pixar's sales have risen an average 54.4% annually, while profits have jumped 55.9% a year.

Pixar is the only movie maker on this year's Hot Growth list, but it is far from alone in its ability to thrive. Small companies continue to boost a sputtering economy by hooking customers on their distinctive goods and services. They are a prime source of innovation, producing 13 times as many patents as large companies do. They account for 50% of the nonfarm gross national product and create 75% of all new jobs, according to the Microcap Company Political Action Committee in Washington. And as many alumni of the Hot Growth 100 can attest, their hard work often pays off. Past list members who have graduated to the big time include Abercrombie & Fitch (ANF
), Whole Foods Market (WFMI
), Cisco Systems (CSCO
), eBay (EBAY
), and Apollo Group (APOL
), which manages the University of Phoenix.

COLD WINDS BLOW

Being hot never guarantees longevity. The small-company world is rife with volatility. Some past Hot Growth entrants ended up on our list after staging spectacular turnarounds but then failed to sustain enough growth to keep them on top. Others were fueled by fads or trends that turned stale, and then they got left in the dust when their customers moved on to the next big thing. Investors are particularly unforgiving of small, fast-growing companies that turn cool, making this sector an especially risky one.

For some on this year's Hot Growth list, success has been a hard slog. No. 10 Laserscope (LSCP
), a San Jose (Calif.) maker of medical devices, made the list in 1991 but then faltered as it tried to sell its laser-based systems in too many markets. In 1999, CEO Eric M. Reuter refocused marketing efforts on the rapidly growing population of aging baby boomers. Today, Laserscope is back on top, thanks to a line of products called GreenLight, used to treat enlarged prostates -- a condition that 30% of men over the age of 50 will eventually develop.

Laserscope's solution lit up a sorely underserved market. The standard treatment for enlarged prostates has been surgery that can cause dangerous bleeding and loss of sexual function. The operation is so dreaded that urologists jokingly refer to it as the Roto-Rooter. Now many of them are using Laserscope's device instead. It fires a green laser directly at the blood vessels in the enlarged prostate gland, which vaporizes the abnormal tissue, causing few side effects. "It's like a blowtorch on a snowbank," Reuter explains. Laserscope earns about $600 per procedure by selling a disposable fiber-optic catheter that must be replaced each time the GreenLight machine is used -- a classic razor/razor-blade business model. In the three years since it introduced GreenLight, Laserscope has seen its sales jump an average 38% a year. Profits in the first quarter of this year rose 124%, to $5 million, on sales of $28.2 million.

Laserscope isn't the only small company profiting from an aging population. This year, 17 members of the Hot Growth list are manufacturers of medical devices and other health-related products -- making health care the most heavily represented industry. Experts say the sector is being buoyed not only by demographics but also by enthusiastic investors. They're hoping to get in early on medical-device successes -- in essence trying to spot the next Boston Scientific Corp. (BSX
) or Medtronic Inc. (MDT
). "A lot of these companies have taken off beyond the moon, and investors are excited," says Jack Wynn, manager of the Microcap Company Political Action Committee.

Many health-care companies on our list are enjoying huge investor support. They include No. 81 Ventana Medical Systems Inc. (VMSI
), a Tucson company that makes diagnostic tools, which has seen its stock fly 66.6%, to 42 a share, in the past year. Shares of No. 4 Palomar Medical Technologies Inc. (PMTI
) in Burlington, Mass., have run up 48.7% in that time. The Russell 2000 Health Care Index, by contrast, has returned just 1.8% over the past year, pulled down by weakness in the pharmaceutical and biotech sectors.

Concerns about terrorism are bolstering companies that make security-related products. No. 1 on our list, Cogent Inc. (COGT
), makes fingerprinting systems, facial-recognition software, and other technologies used by law-enforcement agencies and the U.S. government's Homeland Security Dept. And the South Pasadena (Calif.) company's systems were used to validate voter eligibility in Venezuela's elections. It's no wonder Cogent's sales have grown 89.4% per year on average for the past three years and profits are up 332.3% annually.

HOW SWEET IT IS

To craft our list of superachievers, BusinessWeek sifts through a database of 2,200 publicly traded companies with revenues of $50 million to $1.5 billion a year. Then we rank them by sales and earnings growth, as well as return on capital over three years. Contenders must have a market cap of $25 million or more and a stock that trades for at least $5 a share. We ax companies whose shares are underperforming the NASDAQ composite index. Recent earnings disappointments also disqualify some finalists. The top 100 survivors make our list.

The raw numbers prove how sweet life can be for small companies with big ideas. Sales for the 100 top finishers grew an average annual 30.7% over three years. Annual earnings jumped a staggering 118.9%. The S&P Industrials, by comparison, posted revenue growth of just 7.3% a year and earnings growth of 34.6%. The Hot Growth management teams also displayed a talent for investing their assets. The average return on capital was 14.8% -- more than double that of the S&P Industrials.

Companies that address upscale audiences excelled this year, including retailers Coldwater Creek Inc. (CWTR
) (No. 70) and Chico's FAS Inc. (CHS
) (No. 15), which is making a remarkable seventh appearance on the Hot Growth list. New to the list this year is Tempur-Pedic International Inc. (TPX
), maker of pricey mattresses, pillows, and other sleep-friendly products. Tempur-Pedic -- invented by a couple of Swedish entrepreneurs in conjunction with NASA -- was originally marketed directly to consumers as an alternative to mass-market bedding. "We were the back-pain mattress," says CEO Robert Trussell Jr., who obtained exclusive rights to distribute Tempur-Pedic products in the U.S. in 1992.

After consumers saw Tempur-Pedic's ads on TV, they began asking for the mattress in furniture stores, most of which did not carry it. "That really greased the wheels," says Trussell, who set out to respond to customer demand by increasing Tempur-Pedic's retail presence. The products are now carried in 4,600 stores, including chains such as Brookstone (BKST
), Linens 'n Things (LIN
), and Bed Bath & Beyond (BBBY
). Thanks to strong retail demand, Tempur-Pedic's sales have jumped an average 47.1% annually for the past three years, and profits have risen 88.6% a year, placing the Lexington (Ky.) company 62nd on our list.

"AHEAD OF THE PUCK"

Anticipating customers' needs is important in any industry, but in a struggling sector it can make the difference between simply surviving and thriving. While information technology hasn't made a big comeback quite yet, some tech companies have roared onto the Hot Growth list by targeting fast-growing pockets of demand. No. 46 Avid Technology Inc. (AVID
), for example, sells editing software to film and TV producers. Avid's profits have grown an average 389% annually over the past three years.

Avid was one of the first companies to introduce a line of digital editing tools for high-definition television production. HDTV has been slow to catch hold, but Avid's faith that the new tech format would eventually prevail is beginning to reap dividends. Last season, 28 TV shows were created with Avid's HD tools -- a 40% increase over the previous year. CEO David A. Krall likens his job to that of a hockey player. "We spend a lot of time looking at trends and trying to get out ahead of the puck," he says.

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One of Avid's most loyal customers is fellow Hot Growth entrant Pixar, which used Avid's software to create The Incredibles. Clearly, when you're small, it helps to ride the coattails of your fast-growing friends. But as these and the other Incredibles on the Hot Growth 100 show, it's innovation, nimbleness, and plain old smarts that ultimately set the winners apart from those who are just mediocre.